The semiconductor industry downturn hit Qualcomm (QCOM 1.45%) particularly hard. Shares rallied a bit so far in 2023, but the stock remains some 36% below all-time highs. The smartphone market is in disarray, so it's little surprise that Qualcomm (which derives most of its sales from mobile devices) is down so much and trailing behind its peers' recent rally (as measured by the iShares Semiconductor ETF).
But there's an oft-overlooked aspect of Qualcomm's business that has dragged shares down, and a reason the stock could take flight once more later this year. Here's why I'm a buyer.
Data by YCharts.
Qualcomm isn't quite "fabless"
Qualcomm is frequently mentioned as a "fabless" semiconductor company -- meaning it only designs chips, outsourcing the manufacturing to third parties like GlobalFoundries, Samsung, and Taiwan Semiconductor Manufacturing.
But Qualcomm isn't completely fabless. Per Qualcomm's 2022 annual report:
[Qualcomm CDMA Technologies] primarily uses internal fabrication facilities to manufacture certain RFFE modules and RF filter products, and our manufacturing operations consist of front-end and back-end processes. The front-end processes primarily take place at manufacturing facilities located in Germany and Singapore and involve the imprinting of substrate wafers with the structure and circuitry required for the products to function (also known as wafer fabrication). The back-end processes include the assembly, packaging and test of RFFE modules and RF filter products and their preparation for distribution. Our back-end manufacturing facilities are located in China and Singapore.
Basically, the majority of Qualcomm's fabless chip design business uses manufacturing partners. But its wireless connectivity chips (not the Snapdragon mobile processors and related chipsets) are made in-house. This is a similar business model to that of fellow chip design giant Broadcom.
In fiscal year 2022, Qualcomm said the RF front-end (RFFE) chips that enable devices like smartphones and tablets to hook up to a mobile network hauled in $4.3 billion worth of sales, or about 10% of total revenue.
Qualcomm started lumping RFFE sales in with its handsets, Internet of Things, and auto segments, depending on which end market purchased them. But it's significant that RFFE is an in-house manufacturing process, given that these wireless chip sales are in the hardest-hit part of the semiconductor market right now. Manufacturers in particular get hit hard by downturns, since fabs are a fixed cost. Regardless of where Qualcomm is in the sales cycle, much of those fabs' costs must be paid -- which means profit margins slump more than average during downturns like the current one.
To wit, while Qualcomm CDMA Technologies revenue dipped 11% year over year in the latest quarter (Q1 fiscal 2023), earnings before tax fell 30%.
The pain shows up on the balance sheet
To help manage the present chip industry decline, Qualcomm held back some shipments to its customers. Instead, Qualcomm has been accumulating inventory. This explains why a "fabless" company like Qualcomm is carrying so much chip inventory on its balance sheet. In the last quarter, inventories were listed at $6.9 billion, almost double what was in stock at the end of 2021.
This spike is pretty wild, considering Qualcomm's historical inventory levels.
Data by YCharts.
CFO Akash Palkhiwala said on the last earnings call that inventory will begin to normalize during the second half of this year, echoing calls from most other semiconductor companies. He added that Qualcomm remains "in a strong position to take advantage of the opportunity when it occurs."
Why big inventory spells opportunity
What Qualcomm's management team is saying here is that though the smartphone and mobile device market is depressed right now, a spike in demand is on the horizon. Qualcomm's elevated inventory could eventually turn into a surge in sales -- and a surge in profits -- driven by ongoing upgrades to the 5G mobile network and other fixed wireless and internet infrastructure upgrades.
I'm not so sure the general market has caught on to this dynamic yet. Qualcomm stock currently trades for less than 12 times trailing-12-month earnings per share and at about 17 times trailing-12-month free cash flow (the latter metric is higher due in large part to that inventory build and other hard asset investments).
Companies that have reported earnings since Qualcomm's last report -- most notably Micron Technology -- are indicating that the semiconductor industry downturn is nearing its end. Though Qualcomm's next quarter or two will likely be ugly, any indication that the next boom-time cycle is coming could provide big upside for Qualcomm stock. That's why I'm a buyer right now.
